U.S. Tax Code Doesn’t Favor the Saver for a Cushy Retirement

John Shoven is an economist who has studied and taught finance at Stanford University for 24 years. So, he’s not surprised by the notion that the U.S. tax code contains a system of rewards and penalties for specific behavior.

After all, it’s no secret that if you buy a house, give to charity or have a child, the government rewards you with a tax deduction. Meanwhile, if you pull money out of a retirement plan too soon--or if you pay your income taxes too late--you get hit with a penalty.

Still, Shoven never imagined that the government would slam Americans with walloping penalties for doing something that Uncle Sam fully encourages: saving consistently and aggressively for retirement. But if you save “too much,” by the federal government’s estimation, you get hit with some stunning taxes. Between income, excise and estate taxes, a middle-income American can find that more than 50%--and sometimes more than 90%--of their pension savings gets taxed away.

“It is hard for me to believe that Congress thinks it makes sense to hit somebody with a 95% tax rate,” Shoven says. “I have to think that if they understood this, they would change it.”

Could you be hit? If you are a diligent saver--someone who socks away 10% of income year after year in qualified retirement plans--the chance is very good. If you are age 50 and have amassed pension savings of $500,000 or more, your chances are great, Shoven says. Meanwhile, if you are older and retired (or nearing retirement), have $1 million in retirement savings and have substantial assets--a valuable house, cars, jewelry, for example--there’s a better-than-average chance that your kids will be hit with a walloping tax bill when you die. If you’re not likely to have $1 million saved by retirement, you probably don’t have to worry.

However, big savers who understand the tax law well enough to react can avoid a good portion of the pain.

The issue revolves around a handful of tax provisions that were instituted in the early 1980s and 1990s. In a nutshell, these provisions were designed to stop extremely rich people from sheltering the bulk of their income from tax by placing it into tax-favored retirement accounts.

The law doesn’t, however, impose penalties on those who put too much money into a plan. The penalty comes when the money is taken out. Consequently, people who simply saved a little bit of money over a long time can get hit, as can those who simply earned double-digit returns on their money.

“With the way the stock market has gone the last three or four years, it seems that more people are being pushed into this bracket than Congress anticipated,” says Philip J. Holthouse, a partner at Holthouse, Carlin & Van Trigt, a Los Angeles-based tax firm.

How does the law work? If you take pension distributions--from any and all sources--amounting to more than $155,000 a year, you get hit with a penalty tax called an excess distribution tax, which comes to 15% of the amount exceeding the threshold. (The threshold is occasionally adjusted for inflation.)

That excise tax comes on top of the ordinary income taxes you pay on pension money. So, in effect, a Californian who took $200,000 out of a pension would pay about 45% of the whole amount--or $90,000--in income taxes. In addition, the $45,000 that exceeds the acceptable $155,000 pension threshold gets hit with an additional 15% tax--that’s a $6,750 penalty. In total, you pay roughly 49% tax, walking away with just $103,250 of the $200,000 pension distribution.

Can’t you just leave the money in the plan and bequeath it to your kids someday? If you do--and if you have substantial other assets to bequeath as well--far more onerous taxes will result, Shoven says.

Specifically, when you die, your pension assets get hit with income taxes, estate taxes and an “excess accumulation tax”--a penalty tax of 15% of the “excess” amount. What is the excess amount? Determining that requires going through a complicated formula, which takes into account the amount of pension assets and your age at death.

However, Shoven gives an example of what happens to a $100,000 individual retirement account owned by a Californian who died with $3 million in assets, including $1.2 million in other pensions. The $100,000 is hit with a $15,000 excess accumulation tax, a $8,160 California estate tax, a $38,590 federal estate tax and $30,217 in state and federal income taxes. In the end, this person’s heirs receive only $8,033 of the original $100,000 IRA.

And that isn’t even an extreme case, Shoven said. California estates can face a maximum tax amounting to 96.5% on pension assets. In New York, the marginal rate can go as high as 99.73%--leaving this heir with just $270 of that $100,000 IRA.

Notably, thanks to a tax bill passed last year, there is a three-year window in which individuals who have already reached the age of 59 1/2 can withdraw excess amounts from their pension plans without getting hit with the 15% penalty. They would, however, have to pay ordinary income taxes on the money withdrawn. Those who take out a substantial sum will shoot themselves into top income tax brackets, so accountants maintain that you’d have to do some hard mathematical analysis before deciding to use this window.

Meanwhile, those who are younger might want to take their pension distributions annually before they reach normal retirement age, tax experts note. That can give them the ability to avoid the excise taxes without withdrawing as much at once.

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Kathy M. Kristof welcomes your comments and suggestions. Write to her in care of Personal Finance, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or e-mail kathy.kristof@latimes.com